Thursday, February 10, 2011

This question keeps getting asked, since a cornerstone of the move to increase bank reserves is to stimulate more lending. To be plain, let’s make our explanation in the form of an analogy. -between a bank and a retail shop.

A retail shop needs a trade credit line in its normal course of business. With this credit line, it finances many of it purchase of inventories, so it can resell them to the general public. But before it qualifies to get such line, it first needs to have shareholder’s equity in the business. This is proof that the owner has personally invested into the business, and serves to give comfort to the line giver that there is a cushion which will eat the first instance of loss.

In the same manner, a bank needs reserves (whether from deposits or the Fed) in its normal banking business. Via its reserves, it is able to undertake its everyday business of making and disbursing payments, including loans, and paying back depositors on demand.* But before it qualifies for Fed facilities, or before it can attract new deposits, it needs to show that it has adequate equity in the bank first. This is proof that the owner has personally invested into the business, and serves to give comfort to the reserve giver that there is a cushion which will eat the first instance of loss.

For a retail shop, as more of a credit line is used, more equity needs to be set aside in the business, so as to keep from getting insolvent, should a large chunk of line givers suddenly demand their money back. It is also prudent management not to let leverage get out of hand.

With a bank, the more reserves it raises (or borrows), more equity needs to be set aside, so as to keep from getting insolvent, should a large chunk of funders suddenly demand their money back. This is also a requirement of Basel, which if unheeded, causes a bank to get a rating downgrade.

As more lenders provide a retail shop with credit, the greater volume of inventory it can purchase, and hence give discounts to its buyers.

Similarly, the more reserves a bank is given, it is believed, the greater volume of lending it can provide, and hence, and at cheaper rates, to its borrowers.

Given sufficient credit, (and assuming adequate equity), the retail shop eventually runs into the upper limit of saleable inventory it can accumulate. The upper limit is determined by the population of end buyers who can afford to pay for its goods.

Given sufficient reserves, (and assuming adequate equity), the bank eventually runs into the upper limit of prudent lending it can accommodate. The upper limit is determined by the population of good credit borrowers who can afford to pay back their loan.

Of course, if the storekeeper thinks the risk is worth it, he will invest in more inventory using credit. If he sells all of it, he will get rich. But if previous inventory is not selling well, a shopkeeper will use more credit to pay off old credit. If debt accumulates on top of debt, he will have to eat the loss, and at worst, declare bankruptcy. Before this happens, some foolish line givers might decide to give more credit just to postpone the inevitable. But once the credit line has been used, and it was used for reckless inventory hoarding, it can no longer be demanded back.

Of course, if the banker thinks the risk is worth it, he will lend more at inadequate equity (provided he can get away with it). If the loans pay off, he will get rich. If previous loans are getting sour, the bank will use existing reserves to keep paying its daily obligations, including paying back depositors who demand their money back. If there aren’t enough reserves when a large multitude of depositors are demanding their money back, he will have to eat the loss, and at worst, declare bank holiday. But once the Fed has already printed so much reserves into existence, and it was used in reckless lending and speculation, the monetary easing can no longer be reversed without causing a systemic meltdown.

*Not necessarily saying banks lend reserves. If you have a line at the Fed, it becomes fungible with existing reserves.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.